CHAPTER -ONE

INTRODUCTION
1.1 Foundations of economics

Basic question-why study economics?

-What are the facts of economics?
There are two fundamental facts with which the foundation of Economics can be built on.
A) The problem of unlimited wants.
An individual desires and uses goods and services, which provide him/her utility or
satisfaction. These goods and services can be necessity (food, shelter, and clothing) or
luxury (perfumes, yachts, and car).
Human wants refer to all the goods, services, and the condition of life that individual desire.
Human wants vary among different people, over different periods of time and in different
locations. However, human wants are always insatiable or unlimited, which greater than the
goods and services available.
B) The principle of scarcity
Resources are means of producing goods and service that society wants on. Resources can
be categorized into two.
Free resource- is resources at which the quantity supplied exceeds the quantity demanded at
zero prices. To put it clearly, a resource is said to be free if the amount available to society
is greater than the amount people want at zero price. They have zero opportunity cost. For
instance, breathing air, wind, river water, and sunlight.
Economics resource-is resources that are limited in supply so that quantity demand exceeds
quantity supply. In other words, if the availability of a resource is less than the amount
people desire to have at zero prices, the resource is definitely an economic (scarce) resource.
As a result, they command a price and are not free. They have also positive opportunity cost.
Examples are Land, machinery, etc.
Economic resources are also called factors of production. Economic (Scarce) Resources are
classified in to the following:
A) Land/natural resources: - Includes all the gifts of nature or natural resources that
can be used in the production of goods and services- catch all term that covers all of
nature’s endowment. Land does not include readymade resources (those resources
that are transformed, altered, or improved by man). For example, a barren (infertile)
land that has get improved or prepared to be used as a basement for the construction
of a skyscraper is no longer a free gift of nature and hence is not considered as land.
The reward of land is rent.
B) Labor/human resources: - refers to all mental and physical capability or talents
embodied in people that human beings contribute to the production process. Skilled
(expertise, trained, experienced) labor and unskilled labor are the major components. The
reward for labor is wage.
C) Capital: - This refers to all manufactured inputs usable in the production of other goods
and services.
- refers to the various durable manufactured types of capital capable of producing other
goods and services. Examples are equipment, machinery, inventories, etc.

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‘Improved’, ‘altered’, or ‘transformed’ Capital: - refers to those parts of gifts of nature that
are made better, or improved, or altered by people.
Example, The barren land prepared by an investor to be used as a foundation or
basement for a skyscraper or steel smelted from iron ore (ferric oxide, Fe2O3) in
the blast furnace are considered as capital.
The reward for capital is interest.
D) Entrepreneurship: is the special type of human expertise with the objective of making
profits that organizes and manages factors of production and takes the risk of making losses.
The person with such type of special talent is known as an entrepreneur and the reward for
this person is profit.
Characteristics of entrepreneurs or an Entrepreneur is different from labor in that:
- Initiative. It organizes factors of production to produce outputs.
- Decision maker. It makes non-routine(situational) business policy decisions
- Risk-taker. The entrepreneur’s risks can be time, effort, business organization,
the invested funds and those associates or stockholders. Hence, all these look in
both pessimist and optimist(Boserupian) senses.
- Innovator. It is engaged in innovation i.e. attempts to introduce new products,
new production techniques, new form of business organization.
These economic resources are generally limited in supply; the amount of goods and services
that any society can produce is also limited. Society can only satisfy some wants rather than
all wants. Thus, every society faces scarcity.
The existence of scarcity does not imply that most people are poor or that their basic needs
are not being met. Scarcity exists simply because it is human nature for people to want more
than they can have.
Scarcity is the condition where by the resources, goods, and services available to individuals
and society are limited relative to the wants and desires for them. Thus, the term scarcity
reflects the imbalance between our wants and the means to satisfy these wants. The problem
of scarcity lies in the inability of people to produce the quantity and quality of all goods and
services that all people want.
Generally, economics is needed to deal with the problem of unlimited human want and the
principle of scarcity. If human wants were limited and resources were unlimited, there
would be no scarcity and there would be no need to study economics. Nevertheless,
naturally since material want is unlimited and economic resources are limited, the discipline
of economics is needed to deal with.
1.2. Definition of economics
Basic questions
-What is economics?
-Is economics a discipline of consequence?
-Is the study of economics an endeavor worthy of your time and effort?
Economics as a Science and /or discipline can be defined as in a number of ways. However,
On the one hand, Human wants are unlimited. On the other, Economic resources available to
satisfy all these wants are scarce or limited. The insatiable nature of human material wants
and the corresponding scarcity of resources lead to the need for making choices. These
Choices are how to allocate scarce resources to maximize the satisfaction of human wants.
Economics as a discipline therefore gives rise to a way of reasoning on how to allocate
scarce resources efficiently.

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Economics is the study of choosing among alternative ways in which scarce resources may
be allocated to maximize the satisfaction of human wants. It can also be defined as a branch
of social science that is concerned with the efficient utilization and management of limited
productive resources for attaining maximum satisfaction of human material wants. Besides,
many economists have forwarded their own definition of economics, some are:
- It is the study of constrained maximization
- It is the study of choice.
- It is the study of how a society chooses to use its limited resources to produce,
exchange, and to consume goods and services.
- It is a science that studies as to how people use the things they have, to try to get
the most of what they want.
- It is the study of how scarce resources are allocated among competing ends
1.3. Scope of Economics
By scope of Economics, we mean the broadness and narrowness or coverage or major areas
of study. Economics when developed in to a discipline, Comprises two main branches called
microeconomics and macroeconomics.
A) Microeconomics
Microeconomics is a branch of economics that studies the economic decision making of
firms and individuals in a market. It is the study of the economy in the small. It is concerned
with the economic activities of individual or individuals of consumers and producers or
group of consumers and producers. In other words, it is concerned with the specific
economic units and a detailed consideration of the behavior of these individual units.
In Microeconomics, we talk in terms of individual industry, firm, or household and
concentrate up on the functioning of individual industries and the behavior of individual
decision-making units, i.e., single firm (business) and household. Microeconomics is useful
in achieving a worm’s eye view of some of the very specific components of an economy.
Microeconomics examines individual trees in a forest.
B) Macroeconomics
Macroeconomics is the branch of economics that studies the economy at large or the
economy as a whole. It is also the concern of macroeconomics to deal with the sub-
aggregates (sub-divisions) of the economy such as the government, total households in the
economy, the whole industry, and business sector, which make up the economy.
In dealing with aggregates, macroeconomics deals with obtaining general outline or
overview of an economy. In macroeconomics no attention is given to the specific units,
which make up the various aggregates, only the aggregates are a matter of concern.
Macroeconomics entails discussion on such magnitudes as national aggregates like national
income and output, saving and investment, total employment, general price level, etc. It
considers the overall performance of the economy with regard to the above variables and
hence it is sometimes called aggregate economics.
NOTE: Microeconomics also deals with aggregates. For example, we may talk of the total
production, total employment, total market demand (which is an aggregate) of Toyota,
Nissan, Mazda, etc of Japanese firms. It is the concern of microeconomics to study the total

A good is any tangible thing that satisfies people’s wants and desires.
A service is any form of intangible but useful activity that is valued by people.

An aggregate is a collection of specific economic activities or units.

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level of employment in this single automobile industry (which is an aggregate of Toyota,
Mazda, Nissan, and others).

Let’s compare Micro-and Macroeconomics.

Micro economics Macro economics

-Deals with the behavior of - Is Concerned with the
individual economic units and economy at large/as a
decision makers (a house hold, a whole / and with sub-
firm, an industry) aggregates of an economy.
-Is concerned with output, price, - Entails detail consideration of
income, employment, and total output, total income,
consumption determination in total employment and
individual household, firm or general price level in the
industry. economy at large.
-Is with the objective of efficient - Is with the objective of
resource allocation and price maintaining high
determination. employment, maintaining
-Studies aggregates that do not stability of an economy,
facilitating growth and
controlling inflation
- Studies aggregate and sub-
aggregate items such as
1.4 Nature of choice and opportunity cost
Since resources are generally limited in supply, the amount of goods and services that any
society can produce is also limited. Scarcity is the condition where by the resources, goods,
and services available to individuals and society are limited relative to the wants and desires
for them. Thus, the term scarcity reflects the imbalance between our wants and the means to
satisfy these wants. The problem of scarcity lies in the inability of people to produce the
quantity and quality of all goods and services that all people want.
Society cannot have all the goods and services that it wants, but must choose which
commodities to produce and which to sacrifice. In short, society can only satisfy some
wants rather than all wants. Thus, every society faces scarcity.
The availability of a resource (good or service) in small quantities does not suffice for the
scarcity problem to exist, but it is necessary condition. It should be noted that scarcity does
not mean shortage. A resource (good or service) is said to be scarce if the amount available
is less than the amount people want at zero price. But we say that there is shortage of a
resource (good or service) when people cannot get the amount they want at the prevailing or
on going price.
Thus, the sufficient condition for to scarcity problem to exist is that the amount that people
want shall outstrip the available amount of a resource (good or service) at zero prices.
While shortage is a specific and short-term phenomenon, scarcity is a universal and an
everlasting one.
The most obvious implication of scarcity is the need to choose. Because, there are not
enough resources to do everything, people must decide what will be done with resources
available and what cannot be done. The society must make choices about what output to

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produce in what quantities, and what output not to produce, how to produce and for whom to
produce.
As you might well conceive, dealing with the above three economic problems involves
choice. By deciding which goods and services to produce, society will choose these at the
expense of others. In other words, choice implies cost. I.e., choice involves sacrifice. This
means that when choice is made an alternative opportunity is sacrificed.
In our world of scarcity, a decision to have more of one good or service, at the same time
means a decision to have less of another good or service. The value of the next best
alternative that must be sacrificed is, therefore, the opportunity cost of the decision.
On net, opportunity cost is defined as the amount or value of the next best alternative
that must be sacrificed or forgone in order to obtain one more unit of a product.
Example: -Consider a student with only birr 1 at his disposal wants either to watch a movie
or drink a cup of milk. Assume the fee for the movie and the price of the cup of milk is each
birr 1. If the student at last resorts to watch the movie, then it means he would forgo the
milk. Put more clearly, when he decides to watch the movie, at the same time, he is deciding
not to drink the milk. Thus, the cost of watching of the movie is sacrificing one cup of milk.
In short, the opportunity cost of deciding to watch the movie (or simply watching the movie)
is losing a cup of milk (or simply a cup of milk).
Scarcity choice opportunity. This relation is known as economics
equation. The economics equation is clearly illustrated using the production possibilities
curve.
1.5. Efficiency and The Production Possibility Frontier
Once we understand the concept of Scarcity, Choice, and opportunity cost, let’s now see
what we mean by efficiency and production possibility. We are exactly at the center of truth
to conclude that economics is a science of efficiency. To realize efficiency, an economy
must achieve both full employment and full production.
Full employment: - refers to the maximum use of all available resources (factors of
production). It means that no labor (worker) should be involuntarily out of work
(unemployed). i.e., the economy should provide employment for all who are willing and
able to work. In addition, no capital and land should sit idle, ceteris paribus.
Full production: - The employment of all available resources is a necessary but not
sufficient condition to achieve efficiency. Full production must also be realized. By full
production, we mean that all the employed resources shall be used so that they provide the
maximum possible satisfaction of our material wants.
In this case, two types of efficiency are considered:
- Productive efficiency is the production of any particular mix of goods and
services in the least costly way.
- Allocative efficiency is the production of that particular mix of goods and
services that the society wants most.
Since resources are scarce, a full employment, full production economy cannot have an
unlimited output of goods and services. Therefore, people must choose which goods and
services to produce and which to forgo. The necessity and consequence of these choices
can be best understood through the production possibility model.

Production possibility Curve (Frontier)-is a curve or graph that shows the various
combinations of goods and services that can be produced in a full employment, full

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 production economy in which case the available resources are fixed and technology is
constant. The PPF also depicts the maximum amount of one good that the society can
produces given the output level of the other good. Thus, it illustrated the scarcity, choice
and opportunity cost
Assumptions of the PPF model:
1. Two products: -for simplicity, the economy is assumed to produce only two products:
bread, a consumer good and machine, a capital good to produce (bake) the bread.
2. Fixed resources: - The quantity and quality of economic resources available for use
during a certain period are fixed. This means both the quantity and quality of labor;
Land, Capital, and Entrepreneurship are fixed.
3. Fixed technology: - the state of technology-the methods used to produce goods and
services-does not change during specific (given) period of time. However, it would be
unlikely for technology to remain fixed in the long run.
4. Efficiency: - The economy is operating at full employment and achieving full
production. I.e., No resource must sit idle and the employment of these resources must
provide us the maximum possible output level.
5. Possibility of reallocation/shifting of resources: Nevertheless, both the quality and the
quantity of economics resources are fixed, they, within limits, can be shifted or
reallocated among different uses. Example, a plot of land can be used for factory site
or food production. Relatively unskilled laborer can work on a farm, at a fast-food
restaurant or in a gas station.
As a starting point to plot the PPF, let’s see the production possibilities table. This shows
(refers to) the schedule of different combination of two commodities that can be produced
by fully employing available resources within the limits of fixed technology and resources.
Table 1 Production Possibilities schedule

Commodity Production possibilities

type A B C D E
Machine 100 90 70 40 0
Bread 0 10 20 30 40
Given the above hypothetical
production possibilities schedule, the economy has five (5) production possibilities. At
alternative A, the economy would be devoting all its available resources to the production
of Machine (Capital good)); at alternative E, the economy insists in devoting all of its
available resources to produce Bread (consumer good). While these are un-realistic
extremes (alternatives A and E), an economy typically produces both consumer and
capital goods (on alternatives B, C, and D).
Transforming the production possibilities schedule in to Production Possibilities Frontier
(Curve), we place capital goods (Machine) on the vertical axis and consumer goods
(bread) on the horizontal.

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 A
100  B
90 
G
70 C 

 W
Machine

60
Units of

F D
40 

30

E
10 20 30 40
Bread
(No of Loaves)
Figure 1; ppf model
Each point on the production possibilities curve represents some maximum output of the
two products. The curve is a production frontier because it shows the limit of attainable
outputs.
Given the PPF:
- Any combinations of the two commodities ON or WITHIN (to the left of) the
curve are attainable combinations. Example points B with a combination of 10
Bread, and 90 Machine and point F with combination of 20 Bread and 40
- Machines are all attainable Combinations.
- To produce ON the production possibilities frontier (points A, B, C, D, W and
E), a society must achieve both full employment and full production, i.e. a
society is said to be efficient when it cannot produce more of one good without
producing less of another. This happens when the society produces on the PPF.
An efficient economy produces on the PPF because it cannot produce more of
one good without reducing production of another good. Example, point B lies on
the PPF (indicating a combination of 10 loaves of Bread and 90 machines); it
means that the society is producing efficiently. If the society wants to produce
more bread, say 20 loaves Bread, the society is forced to reduce its production of
machine from 90 to 70. Thus, we say that the society is efficient at point B (and
also at points A, C, D, W and E)
- Points inside the PPF (to the left of PPF) indicate that the combination is
attainable but inefficient. Points inside the PPF imply that the economy could
have produced more of both machine and bread (or at least one of them) if it

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 achieved full employment and productive efficiency. In other words, points that
lie inside (With in) the PPF reveal that there are some idle (unemployed)
resources and /or the society is not producing at the least cost possible.
Example, Point F lies inside the curve, where the society produces 10 loaves of bread and
40 machines. In this case, the society is inefficient. Had there been full employment and full
production, the society could have produced more of at least one of the goods (say a shift
from point F to points B or D) or more of both goods (a shift from point F to point C or W).
- Points outside the curve, such as point G, are unattainable within the premise of
existing technology and available resources. Point G is unattainable because
either the resources are not available or the state of technological progress
prevents the resources from being used efficiently. Point G can only be achieved
by increases in resource supply and quality, and technological advance, or in
general economic growth.
On net, there are four important concepts embodied in the PPF or PPC illustrates four
important concepts:
A) Scarcity: The frontier depicts the maximum combinations of two goods that the
society can produce given the resources and technology. Unattainable points, like
point G, outside the PPF indicate the inevitability of scarcity. The point is that
society cannot have unlimited amount of output even if it employs all of its
resources and utilizes them in the best possible way.
B) Choice: - choice among outputs is reflected in the need for society to select
among the variety of attainable combinations of goods lying along the curve. Any
movement on the curve indicates the change in choice. Taking the above PPF as a
reference, let’s consider points B and D. If the society chooses to produce at point
B, at the same time, it is choosing to have more machine and fewer loaves of
bread. Similarly, if it chooses to produce at point D, the society is choosing to have
more bread and fewer machines. Choice is indicated in the graph by the movement
along the curve either downward or upward (i.e. from point A to B to C to D or to
E or vice verse).
C) Opportunity cost-: when the economy produces on the PPF, production of more
of one good requires sacrificing some of another good. The downward (Negative)
slope of the PPF implies the notion of opportunity cost. Opportunity cost of a
given product is the amount of some other product, which must be forgone or
sacrificed to obtain some amount of that given product. Example, in moving
from point B to point C in the above PPF, 20 units of machine must be given up
(forgone) in order to obtain 10 additional loaves of bread. Thus, the opportunity
cost is given by:
Opp cost = Units given up of one good
Units obtained of another good
In our case, Opportunity cost = =2
The Interpretation is: - In order to obtain 1 additional loaf of bread, 2
units of machine must be sacrificed. I.e., the Opportunity cost of obtaining
1 additional loaf of bread is 2 units of machine.

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 D. Increasing opportunity cost/concavity – The concavity of the PPF reveals increasing
opportunity cost. The Law of Increasing Opportunity cost indicates the shape of the PPF is
concave or bowed outward. This reveals that the slope is increasing in either direction,
which means the amount of one good we have to give up in order to obtain the other good
increases along the curve.
The Law of Increasing Opportunity Cost states as more and more of a particular commodity
is produced, the opportunity cost of each additional output increases.
What is the economic rationale for the law of increasing opportunity cost?
- Economic resources are not completely adaptable to alternative uses OR
- Resources are not perfectly substitutable.
Restating, it is important to note the rationale behind the Law of Increasing Opportunity
Cost. Increasing opportunity cost and the outward bowed shape (concavity) of the PPF
arises from the fact that scarce resources are not equally productive in all activities, i.e.
economic resources are not completely adaptable to alternative uses or many resources are
better at producing one good than at producing others.
Taking the above PPF as a reference, let’s exemplify the concept of increasing opportunity
cost.
Table 2 the Law of Increasing Opportunity Cost
Movement Opportunity cost of Opportunity cost of producing
along the curve producing one loaf of one unit of machine
bread
From: A to B 1
B to C 2
C to D 3
D to E 4

From: E to D ¼
D to C ⅓
C to B ½
B to A 1

Economic Growth and the PPF

By economic growth, we mean an increase in the real output level of an economy over time.
Causes/ingredients of economic growth
I. Supply factor/ ability to grow
-quantity and quality of economic resources
-stock of real capital
-state of technology
II. Demand factor-in order to realize its growing productive potential, a nation must
provide for the full employment of its expanding supplies of resources. This refers
to the aggregate demand.

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 III. Allocative factor- to achieve its productive potential, a nation must provide not
only for the full employment of its resources but also for full production from
them. It refers to good and effective policy.
Thus, increases in total output level occurs when there is an increase in the quantity and /or
quality of economic resources such as labor, natural resources, capital, etc. and advance
(progress) in technology, i.e. when methods or techniques of production are improved.

Capital Original PPF

New PPF
goods

Economic
Growth
PPF2
Recession

PPF1

Consumer goods
The increase in total real output (economic growth) is reflected by the outward (rightward)
shift of the PPF. When economic growth is realized, the production possibility frontier shifts
outward to the right (from PPF1 to PPF2).
1.6. Economic problems and economic systems
There are three important economic problems/ questions
1. What / when/ where/ how much to produce? - This is the problem of choice
between commodities. Answering this question amounts to determining the
type (kind) of goods and services and their respective quantities that society
chooses to produce with the limited resources available.
This concept includes questions like what should the societies produce? Should it produce
consumer goods (food, Television, Car, etc.)? or capital goods (machinery, building, etc.)?
Should the scarce resources be allocated to civilian or military equipments?
In a market economy (Capitalist economy) the function of what to produce is accomplished
by the price system (by the forces of demand and supply). In this case, consumer
sovereignty is guaranteed.

2. How to produce? – This is a question related to the technology and

organization of factors of production. This refers to the technology of
production i.e., to the way in which resources or inputs are organized to
produce goods and services. The choice of optimum technical process that
makes the maximum use of abundant resource is the nucleus of this concept.


Consumer sovereignty is the idea that consumers ultimately dictate what will and will
not be produced by deciding what to and not to purchase.

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 Should the society adopt labor-intensive technique of production (techniques
that use large labor) or capital-intensive (the technology that makes maximum
use of capital) techniques?
While the price mechanism determines the solution in market economy, this question is
answered by the decision of central authorities in the command economy.
3. For whom to produce? – This is the problem of distribution and
consumption. It refers to the way through which the output produced can be
distributed among the members of society. This is concerned with the
distribution of national output among the various factors of production (Land,
Labor, Capital, and entrepreneurship).
In the market economy (free-enterprise economy), the price system determines the
distribution pattern of national output among the various society’s members or factors of
production. As modern governments are welfare-oriented, they often interfere to make the
pattern of output (income) distribution more efficient and equitable.
The circular flow model
In economics, the circular flow diagram represents the organization of an economy in
economic model. This diagram contains households, firms, government sector markets for
factors of production, and markets for goods and services

Payment Governmen Wage&sal

forgood t sector aries
s

Taxes
Taxes

The flow of inputs and outputs

Households provide the factors of production (labor, land, and capital) to the firms through
the markets for factors of production. The firms will then use these factors of production to
produce goods and services to be sold in the markets for goods and services. The households
will then buy these goods and services from the firms through the market for goods and
services.

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The flow of dollars
Firms pay wages, rent, and profit to the households for their supply of the factors of
production in the market for factors of production. Households will use this income to spend
on goods and services supplied by the firms in the market for goods and services. When
households spend money on these goods and services, firms will earn revenue which can
then be reinvested to obtain more factors of production.
Households and firms interact in two ways one as sellers and buyers of input and two as
buyers and sellers of output. The sale and purchase of input make factor market where factor
prices are determined and sales and purchase of goods and services creates product market
where product price are determined.
Government- collects taxes from the households and firms. It uses tax revenue to buy labor
and material to perform its functions.
NOTE: The capital that is mentioned as a factor of production is not money. Instead, it is
machines and equipment’s that are needed in the production process.

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